ECONOMIC COMMENTARY
Markets shifted their attention from tariffs and trade policy back to the Federal Reserve, which cut interest rates twice during the fourth quarter to bring the Federal Funds target rate down to 3.5%-3.75%. The decision to cut was not made lightly, with numerous Fed officials expressing hesitation to cut rates while inflation remains well above the central bank’s 2% target. A government shutdown delayed key economic data, and the Fed was ultimately forced to decide on rates with limited visibility into the current state of the US labor market and inflationary environment, sparking the unusual amount of dissent within the Fed and leaving investors guessing on the path of interest rates heading into 2026.
The Fed’s official inflation benchmark, the Core Personal Consumption Expenditures (PCE) price index, is only presently available through September 2025, so the Fed is missing the entire final quarter of 2025. September Core PCE was 2.8%, while the alternative inflation measure of the Core Consumer Price Index is available through November 2025 and shows core inflation at 2.6%. Headline inflation, which includes more volatile
food and energy data, is slightly higher at 2.7%.
Tariffs are a major contributor to inflation but could potentially be removed from the equation, by court ruling or voluntarily, as was the case with tariffs on kitchen cabinets and furniture that received a one-year reprieve. The Supreme Court is expected to weigh in on the legality of the tariffs in the first half of the year, with the consensus of most legal experts being that the Trump administration overstepped and the tariffs should be reversed. Economists estimate that removing tariffs would result in an immediate, one-time 0.5-0.7% reduction in inflation, which would bring the rate down to near the Fed’s 2% target.
With inflation running well above target, the Fed justified its two rate cuts on the grounds that labor market weakness is the greater threat. The unemployment rate of 4.6% (as of November 2025) is the highest since September 2021, and jobs growth has stagnated to an average of just 22,000 per month over the most recent quarter of data. The March 2025 negative revision of 911,000 jobs was partially due to the shortcomings of the Bureau of Labor Statistics’ model, and the agency has been hit by budget and staffing reductions that have led to increased interpolation of data. Fed Chairman Jerome Powell suggested the BLS is overstating growth by as much as 60,000 jobs per month, which would mean the economy has been losing jobs for at least the last three months. A February 2026 revision to the BLS model is scheduled which should provide a clearer picture of the actual employment situation.
Despite the struggles in balancing the opposing forces of inflation and employment, the Fed has some wiggle room thanks to US Gross Domestic Product (GDP) growth that vastly exceeded expectations in the third quarter. GDP clocked in at 4.3% during the quarter, far outpacing estimates thanks to strong consumer spending, a reduction in the trade deficit, and increased government spending. While consumer spending has been the big driver of economic growth for several years, the underlying data shows a shift from discretionary purchases to necessities drove the GDP surge. Rising costs of healthcare and health insurance accounted for 0.8% of the 4.3% GDP gain as healthcare inflation has outpaced other categories and is straining household budgets. There may have been some “pull-forward” spending in healthcare as households accelerated procedures and drug treatments before expected insurance premium hikes and coverage changes take effect in 2026.
The Fed will once again be in “wait-and-see” mode to begin the new year, despite intense political pressure from President Trump and the likely announcement of a loyalist Fed Chair who will advocate for the President’s demand of much lower rates. Fed policymakers have penciled in only one additional 0.25% rate cut for 2026, while markets anticipate two or three cuts. The voting members of the Fed rotate each year and four mostly-hawkish outgoing members will be replaced by a balanced mix of hawks and doves, skewing the overall committee more dovish, i.e., in favor of rate cuts.
MARKET COMMENTARY
US equities turned in a relatively modest fourth quarter as the S&P 500 gained just 2.7%, ending the year with an impressive 17.9% performance. Technology stocks with artificial intelligence (AI) exposure continued to carry the market despite concerns over “circular investment” deals and the return on investment from aggressive spending on AI. Technology stocks ended the year with a 24.6% gain, outpacing all other sectors. The dominance of Technology stocks is even more impressive considering the sector gained over 67% from the April low following the announcement of President Trump’s global tariffs.
Heading into the year, investors were looking forward to a broadening out of AI to impact other sectors, and that has come to fruition with Industrials and Utilities riding the coattails of Technology stocks as data center construction continued at a frenetic pace. Industrials gained 19.3% during the year and Utilities advanced 16.0%. The buildout of data centers and the ravenous demand of electricity and water needed to power them is a theme that is likely to continue for some time, although there are signs of pushback from municipalities as AI drives up energy costs and raises environmental concerns for communities.
Inflation bit into Consumer Staples sector returns as shoppers became more cost-sensitive and sought cheaper alternatives to brand names. Consumer Staples companies operate on thin margins, which were strained by tariffs causing input costs to rise sharply. The Consumer Staples sector ends the year with a lackluster gain of just 1.5% as investors sought out higher-growth sectors and bonds offered yields that were competitive to the sector’s dividend appeal.
The top-heavy nature of the market was a concern heading into the year and it only got worse during the quarter, with the top 10 stocks growing to a historic 41% of the S&P 500 market capitalization. Earnings growth remained the primary fundamental support for the bull market. Following the 10.3% growth in Q2 and 8.0% in Q3, Q4 earnings are tracking at a 7.2% growth rate. The S&P 500 ends the quarter at all-time high levels with valuations that have become stretched to 23.2x forward earnings, near the 24x dot-com peak. The valuations are even more frothy for the top 10 companies, which trade at 29x earnings while the remaining “S&P 490” is priced at a more reasonable 19.3x multiple.
US Small Cap stocks have been viewed as a coiled spring for some time now, but the long-awaited breakout remained on hold during the quarter as small caps underperformed their larger peers with a 2.2% quarterly return for the Russell 2000 index. The narrative for a potential Small Cap rally is rooted in historically cheap valuations, trading at a P/E discount relative to large caps. Small Caps were also expected to benefit from cheaper financing as the Fed cuts rates, but the central bank is increasingly pushing on a string, influencing the short end of the yield curve but unable to budge longer term rates.
It remains uncertain whether AI will be positive or negative catalyst to smaller companies. On one hand, the broadening adoption of AI should enable smaller companies to implement analytics, marketing, and other data-driven efficiencies with lower headcount and level the playing field. The counterpoint, evidenced by the gargantuan market cap gains of the largest AI stocks, is that the competitive advantage of mega-caps will only grow as they spend aggressively on AI integration, and the gulf widens further.
Investors who looked beyond the borders of the US were rewarded in 2025 as foreign Developed Market (DM) stocks outperformed with a 4.7% gain to cap off a 31.6% return in 2025. DM countries have thus far emerged as the winners of the Trump tariffs, securing trade negotiation wins or circumventing the tariffs through supply chain rerouting. While the tariffs have driven US inflation to near 3%, countries such as France and Italy have seen their inflation decline as low as 1.5%. Arguably the biggest driver of DM outperformance has been US dollar weakness, which has accelerated as the Republican-controlled Congress shunned austerity in favor of record-setting levels of government spending.
Japanese stocks outperformed with a 11.3% gain in the Nikkei 225 for Q4 as new Prime Minister Sanae Takaichi advocated for pro-growth reforms over budget balancing. Takaichi’s initiatives are intended to stimulate investment in high growth areas such as AI, semiconductors, quantum computing, and biotechnology, while also lowering the cost of living for Japanese citizens. Thus far, investors have cheered the change in direction, propelling the Nikkei to a 29.0% total return during the year.
Emerging Market (EM) stocks also outperformed US stocks in 2025, with a solid 4% fourth quarter return. While a weaker US dollar contributed heavily to the EM gains, exposure to the growing AI industry was also a major driver with many AI supply chain companies domiciled in EM countries such as China, South Korea, and Taiwan. China has been the main trade adversary of the Trump administration and has shown a willingness to exert its leverage over rare earth minerals to extract tariff exemptions. If the emergency powers argument for tariffs is struck down by the US courts, China and other EM countries would benefit, although the Trump administration has expressed a willingness to pursue other pathways towards tariffing foreign goods.
Fixed income asset classes turned in a decent quarter across most asset classes, with short-duration assets and credit outperforming long-term bonds as the Fed’s rate cuts steepened the yield curve. Strong US GDP growth quelled recession fears and led to narrower credit spreads for US investment grade and high yield corporate bonds. US high yield bonds tacked on 1.4% for the quarter to cap off a solid 8.5% total return for the year. Emerging market local currency bonds were major outperformers as the US dollar weakened, gaining 3.4% during the quarter.
The Fed has been under political pressure to cut rates under the assumption that doing so will make mortgages and auto loans more affordable, but the long end of the yield curve ended slightly higher than where it began. Investors are demanding higher term premium to take on the risk of holding bonds while the government
spends recklessly, and the Fed’s control over the long end of the yield curve appears likely to remain minimal if the budgetary disfunction continues.
CLOSING REMARKS
US stocks have achieved three consecutive years of double-digit returns, a feat that has only happened six times since the 1940s. It would not be surprising to see a short-term pullback from present levels early in 2026 as markets sit at all-time highs on relatively pricey valuations. The uncertainty over the inflation/employment dynamic, late-arriving and possibly revised economic data, political drama that extends to the Federal Reserve leadership, geopolitics back on the front page in full view, and many other factors suggest a pause in the rally is due.
There are also concerns over the longer-term implications of a “K-shaped” economy as inflation bears a heavier toll on middle-and lower-income Americans, but data on rental costs and home prices suggest they may see some relief in those areas, which make up a sizable portion of overall consumer spending. Additionally, there are numerous upside catalysts in play with tax cuts about to enter the economy, AI continuing to deliver impressive earnings results, and likely stimulus ahead of the mid-term elections. Investors who have stayed the course have been rewarded in recent years, and we believe that will be the most likely outcome once again in the coming year, even if there is some near-term turbulence.